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We are a biomedical company that develops, manufactures, and markets lasers in dentistry and medicine and also markets and distributes dental imaging equipment, including cone beam digital x-rays and CAD/CAM intra-oral scanners. Our dental laser systems allow dentists, periodontists, endodontists, oral surgeons, and other specialists to perform a broad range of dental procedures, including cosmetic and complex surgical applications. Our systems are designed to provide clinically superior performance for many types of dental procedures with less pain and faster recovery times than are generally achieved with drills, scalpels, and other dental instruments. We have clearance from the U.S. Food and Drug Administration (the â€śFDAâ€ť) to sell our laser systems in the United States and also have the necessary approvals to sell our laser systems in Canada, the European Union and various other international markets. Our licensed dental imaging equipment and other related products are designed to improve diagnoses, applications, and procedures in dentistry and medicine.
We offer two categories of laser system products: Waterlase systems and Diode systems. Our flagship product category, the Waterlase system, uses a patented combination of water and laser energy to perform most procedures currently performed using dental drills, scalpels, and other traditional dental instruments for cutting soft and hard tissue. We also offer our Diode laser systems to perform soft tissue, pain therapy, and cosmetic procedures, including teeth whitening. We currently have approximately 160 issued and 150 pending U.S. and international patents, the majority of which are related to our core Waterlase technology and dental and medical lasers. Since 1998, we have sold over 9,500 Waterlase systems, including more than 5,500 Waterlase MD Â® and iPlus Â® systems, and more than 21,600 laser systems in over 60 countries around the world.

We currently operate in a single reportable business segment. We had net revenues of $57.4 million, $48.9 million, and $26.2 million in 2012, 2011, and 2010, respectively, and we had net losses of $3.1 million, $4.5 million, and $12.0 million for the same periods.

We were originally formed as Societe Endo Technic, SA (â€śSETâ€ť) in 1984 in Marseilles, France, to develop and market various endodontic and laser products. In 1987, SET merged into Pamplona Capital Corp., a public holding company incorporated in Delaware. In 1994, we changed our name to BIOLASE Technology, Inc. and to BIOLASE, Inc. in 2012. Since 1998, our primary objective has been to be the leading designer, manufacturer and marketer of laser systems for the dental industry.

Recent Developments

Product Offerings

In October 2012, we expanded the line of dental imaging products by executing a definitive five-year agreement with Copenhagen-based 3Shape Corporation (â€ś3Shapeâ€ť), making the Company a distributor of 3Shapeâ€™s TRIOS Â® intra-oral CAD/CAM scanning technologies for digital impression-taking solutions in the U.S. and Canada. Among other capabilities, the TRIOS offers on-screen visualization of the impressions with online communication with dental laboratories. We are currently selling this product as a distributor under the manufacturerâ€™s regulatory market clearances.

In September 2012, we introduced the Epicâ„˘, which received the CE Mark in late September 2012 and which received FDA 510(k) clearance in October 2012. This innovative diode laser provides versatility with soft tissue surgery, teeth whitening, and pain therapy capabilities in a portable and convenient design with pre-set and customizable settings. Weighing only two and a half pounds, the Epic diode laser has 10 Watts of power. The Epic V-Series launching in 2013 is based on the Epic platform with software and delivery adaptations enabling a wide range of veterinary applications, including surgical, dental, and pain therapy procedures. We anticipate further expansion of the Epic diode laser into additional medical markets in 2013.

In February 2012, we introduced the Waterlase MDXâ„˘ line, a new product line of all-tissue lasers which expands the Companyâ€™s product offerings and complements the industry-leading Waterlase iPlus all-tissue dental laser system. Two models of the Waterlase MDX are available. The 8-watt Waterlase MDX 300 improves on Biolaseâ€™s time-tested Waterlase MD platform with an updated user interface, a new laser engine and a new lightweight and more flexible titanium fiber cable. The Waterlase MDX 450 increases the power output to 9-watts and cuts hard-tissue up to 70 percent faster than the Waterlase MDX 300. The Waterlase MDX 300 is upgradeable in the field to the MDX 450 performance level.

In February 2012, we introduced NewTom Cone Beam three-dimensional (â€ś3-Dâ€ť) Imaging products, manufactured by Cefla Dental Group, which we distribute in the United States and Canada. The NewTom 3-D product line will complement the Biolase DaVinci Imaging dental imaging devices and provide our dental customers a wider and more comprehensive choice of configurations, range of performance, and price points. The NewTom imaging products are typically used in highly complex dentistry cases by periodontists, endodontists, and oral surgeons where more involved and more accurate images are required. We believe that they are increasingly being adopted by general practitioners for use in placing implants. We are currently selling these products as a distributor under the manufacturerâ€™s 510(k) clearances. We initially introduced dental imaging products in July 2011 under the Biolase DaVinci Imaging â„˘ name.

In January 2011, we introduced the Waterlase iPlus Â® , a powerful and intuitive dual wavelength all-tissue dental laser system. We believe the iPlus is our most significant advancement in all-tissue laser technology since we introduced the Waterlase MD â„˘ in 2005. The Waterlase iPlus received FDA 510(k) clearance in the United States in August 2010 and received European CE mark-approval in February 2011.

Credit Facilities Established

On May 24, 2012, we entered into two revolving credit facility agreements with Comerica Bank (the â€śCredit Agreementsâ€ť), as amended on August 6, 2012, (â€śAmendment No. 1â€ť), which provide for borrowings against certain domestic accounts receivable and inventory, as set forth in the $4.0 million revolving credit facility agreement (the â€śDomestic Revolverâ€ť), and borrowings against certain export related accounts receivable and inventory, as set forth in the $4.0 million revolving credit facility agreement (the â€śEx-Im Revolverâ€ť), for a combined aggregate commitment of borrowings of up to $8.0 million. The Credit Agreements mature on May 1, 2014 and are secured by substantially all of our assets now owned or hereinafter acquired. The Credit Agreements require compliance with certain financial and non-financial covenants, as defined therein. If a default occurs, Comerica Bank may declare the amounts outstanding under the Credit Agreements immediately due and payable. As of December 31, 2012, we were in compliance with these covenants.

Termination of Master Distribution Agreement

On September 23, 2010, we entered into a Distribution and Supply Agreement with Henry Schein, Inc. (â€śHSICâ€ť), effective August 30, 2010, (the â€śD&S Agreementâ€ť), which terminated all prior agreements with HSIC. Under the D&S Agreement, we granted HSIC certain non-exclusive distribution rights in North America and several international markets with respect to our dental laser systems, accessories, and related support and services in certain circumstances. In addition, we granted HSIC exclusivity in selected international markets subject to review of certain performance criteria. In connection with the D&S Agreement, HSIC placed two irrevocable purchase orders totaling $9 million for our products. The first purchase order, totaling $6 million, was for the purchase of iLase Â® systems and was fully satisfied during the first quarter of 2011. The second purchase order, totaling $3 million, was for the purchase of a combination of laser systems and was fully satisfied during the third quarter of 2011. The D&S Agreement granted HSIC a security interest in our inventory and assets, including our intellectual property.

On April 12, 2012, we completed a transaction with HSIC (the â€ś2012 Termination Agreementâ€ť) whereby we purchased HSICâ€™s inventory of Waterlase MD Turbo laser systems for approximately $1.1 million and HSIC released its liens on our assets, including our inventory and intellectual property. As part of the 2012 Termination Agreement, we reacquired 153 MD Turbo laser systems at a cost well below market. Pursuant to the terms of the transaction, the entire purchase price was paid by offsetting certain accounts receivable currently due from HSIC from sales made in the normal course of business. None of the funds used to offset the purchase price were related to the original sales of the MD Turbo laser systems that were purchased. As a result of the transaction, we are no longer required to fulfill certain future service obligations and, accordingly, derecognized approximately $155,000 of accounts receivable due from HSIC related to support services previously provided and approximately $142,000 of accrued warranties during the quarter ended March 31, 2012. During the quarter ended June 30, 2012, the Company reversed accrued sales and marketing service liabilities of approximately $350,000 because the liability was extinguished with the closing of the 2012 Termination Agreement. During the year ended December 31, 2012, we sold all laser systems purchased under this arrangement at margins consistent with our comparable laser products.

Industry Background

General

Dental procedures are performed on hard tissue, such as bone and teeth, and soft tissue, such as gum and other oral tissue.
A 2007 American Dental Association (â€śADAâ€ť) Survey of Dental Services Rendered (the â€śADA Studyâ€ť) has estimated that more than 200 million hard tissue procedures are performed annually in the United States. Hard tissue procedures include cavity preparation, root canals and other procedures involving bone or teeth. The ADA study also indicated that more than 1.2 million soft tissue procedures are performed annually in the United States. Soft tissue procedures include operations such as gum line alteration. According to statistics compiled in the ADAâ€™s study, over 90% of hard tissue procedures and 60% of soft tissue procedures in the United States are performed by general dentists and the rest are performed by oral surgeons, endodontists, periodontists, and other specialists.

The ADA estimated that the demand for dental services in the United States will continue to grow due to population growth and the increased awareness of the benefits associated with preventive dentistry in reducing the incidence of oral and systemic disease.

We believe there is a growing awareness among consumers of the value and importance of a healthy smile and its connections to overall systemic health. As such, the dental industry has entered an era of growth and consideration of advanced technologies that allow dentists to perform simple or complex cosmetic dental procedures with minimal trauma, improved patient acceptance and clinically superior results. We believe our product offerings correspond with this trend, and we expect incremental growth from these pressures in the marketplace.

Traditional Dental Instruments

Dentists and other specialists choose from a variety of instruments depending on the tissue involved and the type of procedure. Most procedures require the use of multiple instruments to achieve the desired result.

High Speed Drills . Most dentists use high speed drills for hard tissue procedures, such as preparing cavities for filling and gaining access for performing root canals or shaving and contouring oral bone tissue. Potentially adverse effects associated with drills include thermal heat transfer, vibration, pressure and noise. The cutting and grinding action of high speed drills can cause damage to the patientâ€™s dental structure. The trauma caused to the surrounding tissues can lead to increased recovery times and the need for future crowns and root canals. Additionally, this grinding action of high speed drills may weaken the toothâ€™s underlying structure, leading to fractures and broken cusps. Procedures involving high-speed drills typically require anesthesia. Because many dentists do not recommend anesthetizing more than one or two quadrants of the mouth in a single session, patients may need to return several times to complete their treatment plan. Further, based on the results of several recent studies, autoclaving fails to completely decontaminate dental burs and approximately 15% of these â€śsterilized bursâ€ť carry pathogenic micro-organisms, which may be transferred from patient to patient.

Cutting Instruments . Soft tissue procedures, such as reshaping gum lines and grafting on new gum tissue, are typically performed by oral surgeons or periodontists using scalpels, scissors, and other cutting tools. Due to the pain and discomfort associated with procedures performed with these instruments, most soft tissue procedures require the use of local anesthetic which results in numbness and discomfort, and often require stitches. The use of scalpels, scissors, and other cutting tools typically cause bleeding, post-operative swelling, and discomfort. Bleeding can impair the practitionerâ€™s visibility during the procedure, thereby reducing efficiency and is a particular problem for patients with immune deficiencies or blood disorders, and patients taking blood-thinning medications.

Film Radiography Equipment . Since the early twentieth century, dentists have relied on radiographic images produced by exposing photographic film to X-ray radiation as part of the examination and diagnosis of patients. These X-ray images can help reveal tooth decay, periodontal disease, bone loss, infections, hidden dental structures, abscesses or cysts, developmental abnormalities, some types of tumors, and other issues that might not be detected during a visual examination or upon probing with a handheld instrument. Due to the chemical development process required for film, however, this process is time-consuming, inefficient, and costly for dental offices, and not environmentally friendly. Mistakes in the development process can require retakes which expose patients to additional radiation. Film X-rays also restrict the abilities of doctors to enhance or further manipulate images for easier and more accurate analysis and treatment planning. Furthermore, one of the most critical limitations of film is that it is restricted to two-dimensional images, which can potentially lead to misdiagnosis.

Alternative Dental Instruments

Alternative technologies have been developed over the years to address the problems associated with traditional methods used in dentistry. Most alternatives have addressed either hard or soft tissue applications but not both. The predominant alternative technologies are discussed below.

Electrosurge Systems. Electrosurge systems use an electrical current to heat a shaped tip that simultaneously cuts and cauterizes soft tissue, resulting in less bleeding than occurs with scalpels. However, electrosurge is generally less precise than lasers and can damage surrounding tissue. Electrosurge is also not suitable for hard tissue procedures and, due to the depth of penetration, generally requires anesthesia and a lengthy healing process. Electrosurge generally cannot be used in areas near metal fillings and dental implants. Finally, electrosurge generally cannot treat patients with implanted pacemakers and defibrillators.

Traditional Laser Systems. More recently, lasers have gained acceptance for use in general and cosmetic dentistry. Most lasers used in dentistry have been adapted from other medical applications, such as dermatology, and are not designed to perform a wide range of common dental procedures. Most dental lasers use thermal energy to cut tissue and are used primarily for soft tissue procedures.

Our Solution

Due to the limitations associated with traditional and alternative dental instruments, we believe there is a large market opportunity for all-tissue dental laser systems that provide superior clinical results and help reduce the trauma, pain, and discomfort associated with dental procedures. We also believe there is a large market opportunity for digital radiography systems that improve practice efficiency and accuracy of diagnosis, leading to superior treatment planning, increased practice revenue, and healthier outcomes for patients.

Our Waterlase systems precisely cut hard tissue and soft tissue with minimal or no damage to surrounding tissue and dental structure. Our Diode systems are designed to complement the Waterlase systems, and are used in soft tissue procedures, pain therapy, hygiene, and cosmetic applications, including teeth whitening. The Diode systems, together with our Waterlase systems, offer practitioners a broad product line with a range of features and price points.

The Biolase DaVinci Imaging and Cefla NewTom products are state-of-the-art digital radiography systems that provide both two- and three-dimensional X-ray images as well as intraoral color images that allow doctors to visualize and manipulate significantly more information than previously available with film, without the time delay of film development or cost associated with chemicals and the film itself. These imaging systems have been designed to produce the highest quality images while exposing patients to the least amount of radiation necessary. The Trios intra-oral CAD/CAM scanning product offers diversity in our imaging product line with spray-free, high-speed, 3-D impression capture as well as touch screen and online lab communication capabilities.

A small percentage of dental professionals worldwide currently use lasers. Our laser systems are more expensive than traditional dental tools; however, we believe that the significant clinical advantages of our systems, patient benefits, the potential return on investment that our systems offer practitioners, and the options available to finance the purchase of our systems will enable us to continue to penetrate the global dental market. Laser technologies with similar patient benefits have become standard of care in ophthalmology, dermatology, and other medical specialties. When combined with better information digital imaging, dental lasers will give the doctor the best treatment options to perform more procedures in a minimally invasive manner. This combination of lasers and digital imaging systems makes us the only company to offer high-technology solutions for the diagnosis, treatment planning, and delivery of treatment, in the most minimally invasive manner possible: the Biolase Total Technology Solutionâ„˘.

MANAGEMENT DISCUSSION FROM LATEST 10K

Overview

We are a biomedical company that develops, manufactures, and markets lasers in dentistry and medicine and also markets and distributes dental imaging equipment, including cone beam digital x-rays and CAD/CAM intra-oral scanners. Our dental laser systems that allow dentists, periodontists, endodontists, oral surgeons, and other specialists to perform a broad range of dental procedures, including cosmetic and complex surgical applications. Our systems are designed to provide clinically superior performance for many types of dental procedures with less pain and faster recovery times than are generally achieved with drills, scalpels, and other dental instruments. We have clearance from the FDA to market our laser systems in the United States and also have the necessary approvals to sell our laser systems in Canada, the European Union and various other international markets. Our licensed dental imaging equipment and other related products are designed to improve applications and procedures in dentistry and medicine.

We offer two categories of laser system products: Waterlase systems and Diode systems. Our flagship product category, the Waterlase system, uses a patented combination of water and laser energy to perform most procedures currently performed using dental drills, scalpels, and other traditional dental instruments for cutting soft and hard tissue. We also offer our Diode laser systems to perform soft tissue, pain therapy, and cosmetic procedures, including teeth whitening. We currently have approximately 160 issued and 150 pending U.S. and international patents, the majority of which are related to our core Waterlase technology and dental and medical lasers. Since 1998, we have sold over 9,500 Waterlase systems, including more than 5,500 Waterlase MD and iPlus systems, and more than 21,600 laser systems in over 60 countries.

We have suffered recurring losses from operations and have not generated cash from operations for the three years ended December 31, 2012. In order for us to continue operations and discharge our liabilities and commitments in the normal course of business, we must sell our products directly to end-users and through multiple distributors; establish profitable operations through increased sales and reduced operating expenses; and potentially raise additional funds, principally through the additional sales of our securities or debt financings to meet our working capital needs.

We intend to increase sales by increasing our product offerings, by expanding our direct sales force and our distributor relationships both domestically and internationally. Accordingly, we have taken steps during Fiscal 2012, which we believe will improve our financial condition and ultimately improve our financial results, including increasing our product offerings with the launch of the new Epic diode laser system, for which we received the CE Mark in late September 2012 and FDA clearance in October 2012, executing a definitive five year agreement with Copenhagen-based 3Shape Corporation (â€ś3Shapeâ€ť), making the Company a distributor of 3Shapeâ€™s TRIOS Â® intra-oral scanning technologies for digital impression-taking solutions in the U.S. and Canada, expanding our direct sales force and certain distributor relationships, and establishing two revolving credit facilities to meet our quarterly working capital needs.

Credit Facilities Established

On May 24, 2012, we entered into two revolving credit facility agreements with Comerica Bank (the â€śCredit Agreementsâ€ť), as amended on August 6, 2012, (â€śAmendment No. 1â€ť), which provide for borrowings against certain domestic accounts receivable and inventory, as set forth in the $4.0 million revolving credit facility agreement (the â€śDomestic Revolverâ€ť), and borrowings against certain export related accounts receivable and inventory, as set forth in the $4.0 million revolving credit facility agreement (the â€śEx-Im Revolverâ€ť), for a combined aggregate commitment of borrowings up to $8.0 million. The Credit Agreements mature on May 1, 2014 and are secured by substantially all assets now owned or hereinafter acquired. The Credit Agreements require compliance with certain financial and non-financial covenants, as defined therein. If a default occurs, Comerica Bank may declare the amounts outstanding under the Credit Agreements immediately due and payable. As of December 31, 2012, we were in compliance with these covenants.

As additional consideration for the lines of credit, we also issued warrants to Comerica Bank (the â€śComerica Warrantsâ€ť) to purchase up to 80,000 shares of our common stock at an exercise price of $2.83 per share. The Comerica Warrants vest in four equal quarterly tranches beginning on May 24, 2012 and are exercisable once vested. The Comerica Warrants may be exercised with a cash payment from Comerica Bank, or, in lieu of a cash payment, Comerica Bank may convert the warrants into a number of shares, in whole or in part. In February 2013, Comerica Bank exercised 60,000 of the 80,000 warrants pursuant to the Notice of Exercise resulting in a net issuance of 30,515 shares of common stock. The remaining warrants to purchase 20,000 shares of common stock have an expiration date of May 24, 2017. The $135,000 estimated fair value of the warrants was recorded as equity, resulting in a discount to the credit facilities at issuance. The discount is being amortized to interest expense over the term of the lines of credit. In connection with Amendment No. 1, we reduced the exercise price of the Comerica Warrants from $2.83 to $2.00 per share. The modification to the Comerica Warrants resulted in an incremental expense of $7,000 which was added to the discount and is being amortized on a straight-line basis over the remaining term of the Credit Agreements.

Termination of Master Distribution Agreement

In August 2006, we entered into a License and Distribution Agreement with HSIC, a large distributor of healthcare products to office-based practitioners, pursuant to which we granted HSIC the exclusive right to distribute our complete line of dental laser systems, accessories and services in the United States and Canada.

On September 23, 2010, we entered into a Distribution and Supply Agreement with HSIC, effective August 30, 2010, (the â€śD&S Agreementâ€ť), which terminated all prior agreements with HSIC. Under the D&S Agreement, we granted HSIC certain non-exclusive distribution rights in North America and several international markets with respect to our dental laser systems, accessories, and related support and services in certain circumstances. In addition, we granted HSIC exclusivity in selected international markets subject to review of certain performance criteria. In connection with the D&S Agreement, HSIC placed two irrevocable purchase orders totaling $9 million for our products. The first purchase order, totaling $6 million, was for the purchase of iLase systems and was fully satisfied during the first quarter of 2011. The second purchase order, totaling $3 million, was for the purchase of a combination of laser systems and was fully satisfied during the third quarter of 2011. The D&S Agreement granted HSIC a security interest in our inventory and assets, including our intellectual property.

On April 12, 2012, we completed a transaction with HSIC (the â€ś2012 Termination Agreementâ€ť) whereby we purchased HSICâ€™s inventory of Waterlase MD Turbo laser systems for approximately $1.1 million and HSIC released its liens on our assets. The arrangement enabled us to remove lien restrictions on our assets, including our inventory and intellectual property, and enabled us to reacquire 153 MD Turbo laser systems at a cost well below market. Pursuant to the terms of the transaction, the entire purchase price was paid by offsetting certain accounts receivable currently due from HSIC from sales made in the normal course of business. None of the funds used to offset the purchase price were related to the original sales of the MD Turbo laser systems that were purchased. As a result of the transaction, we are no longer required to fulfill certain future service obligations and, accordingly, derecognized approximately $155,000 of accounts receivable due from HSIC related to support services previously provided and approximately $142,000 of accrued warranties during the quarter ended March 31, 2012. During the quarter ended June 30, 2012, the Company reversed accrued sales and marketing service liabilities of approximately $350,000 because the liability was extinguished with the closing of the 2012 Termination Agreement. During the year ended December 31, 2012, we sold all laser systems purchased under this arrangement at margins consistent with our comparable laser products.

License Agreement

In May 2010, we entered into a License Agreement (the â€ś2010 P&G Agreementâ€ť) with Procter & Gamble Company (â€śP&Gâ€ť), which replaced an existing license agreement between us and P&G (the â€ś2006 P&G Agreementâ€ť). Pursuant to the 2010 P&G Agreement, we agreed to continue granting P&G an exclusive license to certain of our patents to enable P&G to develop products aimed at the consumer market and P&G agreed to pay royalties based on sales of products developed with such intellectual property. The prepaid royalty payments previously paid by P&G were applied to the new exclusive license period from January 1, 2009 through December 31, 2010. At this time, we had deferred royalty revenue totaling $1.9 million from the 2006 P&G Agreement. The 2010 P&G Agreement permitted us to recognize $1.5 million in royalty revenue for the year ended December 31, 2010 related to the 2009 and 2010 exclusivity period. As of December 31, 2010, $375,000 remained in long term deferred revenue. On June 28, 2011, we entered into an amendment to the 2010 P&G Agreement (the â€ś2011 P&G Amendmentâ€ť) which extended the effective period for the 2010 P&G Agreement from December 31, 2010 through June 30, 2011, and resulted in us recognizing the previously deferred $375,000 of revenue as royalty revenue during the quarter ended June 30, 2011.

The 2011 P&G Amendment also provided that effective January 1, 2011, P&Gâ€™s exclusive license to our patents converted to a non-exclusive license unless P&G paid us a license payment in the amount of $187,500 by the end of the third quarter of 2011, and at the end of each quarter thereafter, throughout the term of the 2010 P&G Agreement. As a result of P&G not making any payments to us in the third or fourth quarters of the year ended December 31, 2011, their license converted to a non-exclusive license. We are currently engaged in an active collaboration with P&G to commercialize a consumer product utilizing our patents.

Critical Accounting Policies

The preparation of consolidated financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires us to make judgments, assumptions and estimates that affect the amounts reported. The following is a summary of those accounting policies that we believe are necessary to understand and evaluate our reported financial results.

Revenue Recognition. From September 2006 through August 2010, we sold our products in North America through an exclusive distribution relationship with HSIC. Effective August 30, 2010, we began selling our products in North America directly to customers through our direct sales force and through non-exclusive distributors, including HSIC. We sell our products internationally through exclusive and non-exclusive distributors as well as direct to customers in certain countries. Sales are recorded upon shipment from our facility and payment of our invoices is generally due within 90 days or less. Internationally, we sell products through independent distributors, including HSIC in certain countries. We record revenue based on four basic criteria that must be met before revenue can be recognized: (i) persuasive evidence of an arrangement exists; (ii) delivery has occurred and title and the risks and rewards of ownership have been transferred to our customer, or services have been rendered; (iii) the price is fixed or determinable; and (iv) collectability is reasonably assured.

Sales of our laser systems include separate deliverables consisting of the product, disposables used with the laser systems, installation, and training. For these sales, effective January 1, 2011, we apply the relative selling price method, which requires that arrangement consideration be allocated at the inception of the arrangement to all deliverables using the relative selling price method. This requires us to use estimated selling prices of each of the deliverables in the total arrangement. The sum of those prices is then compared to the arrangement, and any difference is applied to the separate deliverable ratably. This method also establishes a selling price hierarchy for determining the selling price of a deliverable, which includes: (i) vendor-specific objective evidence (â€śVSOEâ€ť), if available, (ii) third-party evidence if vendor-specific objective evidence is not available, and (iii) estimated selling price if neither vendor-specific nor third-party evidence is available. VSOE is determined based on the value we sell the undelivered element to a customer as a stand-alone product. Revenue attributable to the undelivered elements is included in deferred revenue when the product is shipped and is recognized when the related service is performed. Disposables not shipped at time of sale and installation services are typically shipped or installed within 30 days. Training is included in deferred revenue when the product is shipped and is recognized when the related service is performed or upon expiration of time offered under the agreement, typically within six months from date of sale. The adoption of the relative selling price method does not significantly change the value of revenue recognized.

The key judgments related to our revenue recognition include the collectability of payment from the customer, the satisfaction of all elements of the arrangement having been delivered, and that no additional customer credits and discounts are needed. We evaluate a customerâ€™s credit worthiness prior to the shipment of the product. Based on our assessment of the available credit information, we may determine the credit risk is higher than normally acceptable, and we will either decline the purchase or defer the revenue until payment is reasonably assured. Future obligations required at the time of sale may also cause us to defer the revenue until the obligation is satisfied.

Although all sales are final, we accept returns of products in certain, limited circumstances and record a provision for sales returns based on historical experience concurrent with the recognition of revenue. The sales returns allowance is recorded as a reduction of accounts receivable and revenue.
Extended warranty contracts, which are sold to our non-distributor customers, are recorded as revenue on a straight-line basis over the period of the contract, which is typically one year.

For sales transactions involving used laser trade-ins, we record the purchased trade-ins as inventory at the fair value of the asset surrendered with the offset to accounts receivable. In determining the estimated fair value of used laser trade-ins, we make an assessment of usable parts, key components, and consider the ultimate resale value of the certified pre-owned (or â€śCPOâ€ť) laser with applicable margins. We sell these CPO laser trade-ins as refurbished lasers following our laser system revenue recognition policy. Trade-in rights are not established nor negotiated with customers during the initial sales transaction of the original lasers. Trade-in rights are promotional events used at our discretion to encourage existing laser customers to purchase new lasers by offering perceived discounts in exchange for customers trading in original lasers. A customer is not required to trade-in a laser nor are we required to accept a trade-in, however, the promotional value offered in exchange for the trade-in laser is not offered without a laser trade-in. The transaction is treated as a monetary transaction as each sale transaction involving a customer trade-in includes significant boot of greater than 25% of the fair value of the exchange. As a monetary transaction, the sale is recognized following our laser system revenue recognition policy. There have been no sales transactions in which the cash consideration was less than 25% of the total transaction value.

We recognize revenue for royalties under licensing agreements for our patented technology when the product using our technology is sold. We estimate and recognize the amount earned based on historical performance and current knowledge about the business operations of our licensees. Historically, our estimates have been consistent with amounts historically reported by the licensees. Licensing revenue related to exclusive licensing arrangements is recognized concurrent with the related exclusivity period.

From time to time, we may offer sales incentives and promotions on our products. We recognize the cost of sales incentives at the date at which the related revenue is recognized as a reduction in revenue, increase in cost of revenue, or as a selling expense, as applicable, or later, in the case of incentives offered after the initial sale has occurred.

Accounting for Stock-Based Payments . We recognize compensation cost related to all stock-based payments based on the grant-date fair value.
Valuation of Accounts Receivable. We maintain an allowance for uncollectible accounts receivable to estimate the risk of extending credit to customers. We evaluate our allowance for doubtful accounts based upon our knowledge of customers and their compliance with credit terms. The evaluation process includes a review of customersâ€™ accounts on a regular basis which incorporates input from sales, service, and finance personnel. The review process evaluates all account balances with amounts outstanding 90 days and other specific amounts for which information obtained indicates that the balance may be uncollectible. The allowance for doubtful accounts is adjusted based on such evaluation, with a corresponding provision included in general and administrative expenses. Account balances are charged off against the allowance when we believe it is probable the receivable will not be recovered. We do not have any off-balance-sheet credit exposure related to our customers.

Valuation of Inventory. Inventory is valued at the lower of cost, determined using the first-in, first-out method, or market. We periodically evaluate the carrying value of inventory and maintain an allowance for excess and obsolete inventory to adjust the carrying value as necessary to the lower of cost or market. We evaluate quantities on hand, physical condition and technical functionality, as these characteristics may be impacted by anticipated customer demand for current products and new product introductions. Unfavorable changes in estimates of excess and obsolete inventory would result in an increase in cost of revenue and a decrease in gross profit.

Valuation of Long-Lived Assets. Property, plant and equipment, and certain intangibles with finite lives are amortized over their estimated useful lives. Useful lives are based on our estimate of the period that the assets will generate revenue or otherwise productively support our business goals. We monitor events and changes in circumstances which could indicate that the carrying balances of long-lived assets may exceed the undiscounted expected future cash flows from those assets. If such a condition were to exist, we would determine if an impairment loss should be recognized by comparing the carrying amount of the assets to their fair value.

Valuation of Goodwill and Other Intangible Assets. Goodwill and other intangible assets with indefinite lives are not amortized but are evaluated for impairment annually or whenever events or changes in circumstances indicate that the asset might be impaired. We conducted our annual impairment analysis of our goodwill as of June 30, 2012 and concluded there had been no impairment in goodwill. We closely monitor our stock price and market capitalization and perform such analysis when events or circumstances indicate that there may have been a change to the carrying value of those assets.

Warranty Cost. We provide warranties against defects in materials and workmanship of our laser systems for specified periods of time. Waterlase systems sold domestically are covered by our warranty for a period of one year while our Diode systems warranty period is for two years from date of sale by us or the distributor to the end-user. Waterlase systems sold internationally are generally covered by our warranty for a period of sixteen months while our Diode systems warranty period is up to twenty eight months from date of sale to the international distributor. Estimated warranty expenses are recorded as an accrued liability with a corresponding provision to cost of revenue. This estimate is recognized concurrent with the recognition of revenue on the sale to the distributor or end-user. Warranty expenses expected to be incurred after one year from the time of sale to the distributor are classified as a long term warranty accrual. Our overall accrual is based on our historical experience and our expectation of future conditions, taking into consideration the location and type of customer and the type of laser, which directly correlate to the materials and components under warranty, the duration of the warranty period, and the logistical costs to service the warranty. Additional factors that may impact our warranty accrual include changes in the quality of materials, leadership and training of the production and services departments, knowledge of the lasers and workmanship, training of customers, and adherence to the warranty policies. Additionally, an increase in warranty claims or in the costs associated with servicing those claims would likely result in an increase in the accrual and a decrease in gross profit. We do not offer warranties on imaging products which are covered by the manufacturerâ€™s warranties.

Litigation and Other Contingencies. We regularly evaluate our exposure to threatened or pending litigation and other business contingencies. Because of the uncertainties related to the amount of loss from litigation and other business contingencies, the recording of losses relating to such exposures requires significant judgment about the potential range of outcomes. As additional information about current or future litigation or other contingencies becomes available, we will assess whether such information warrants the recording of expense relating to contingencies. To be recorded as expense, a loss contingency must be both probable and reasonably estimable. If a loss contingency is material but is not both probable and estimable, we will disclose the matter in the notes to the consolidated financial statements.

Income Taxes. Based upon our operating losses during 2012 and 2011 and the available evidence, management has determined that it is more likely than not that the deferred tax assets as of December 31, 2012 will not be realized in the near term, excluding a portion of the foreign deferred tax assets totaling approximately $16,000. Consequently, we have established a valuation allowance against our net deferred tax asset totaling approximately $33.3 and $33.8 million as of December 31, 2012 and 2011, respectively. In this determination, we considered factors such as our earnings history, future projected earnings and tax planning strategies. If sufficient evidence of our ability to generate sufficient future taxable income tax benefits becomes apparent, we may reduce our valuation allowance, resulting in tax benefits in our statement of operations and in additional paid-in-capital. Management evaluates the potential realization of our deferred tax assets and assesses the need for reducing the valuation allowance periodically.

Fair Value of Financial Instruments

Our financial instruments, consisting of cash and cash equivalents, accounts receivable, accounts payable, and accrued liabilities, approximate fair value because of the short maturity of these items. Financial instruments consisting of lines of credit approximate fair value, as the interest rates associated with the lines of credit approximates the market rates for debt securities with similar terms and risk characteristics.

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the principal market or, if none exists, the most advantageous market, for the specific asset or liability at the measurement date (referred to as the â€śexit priceâ€ť). The fair value should be based on assumptions that market participants would use, including a consideration of nonperformance risk. Level 1 measurement of fair value is quoted prices in active markets for identical assets or liabilities.

Money market securities. Money market securities are cash equivalents, which are included in cash and cash equivalents, and consist of highly liquid investments with original maturities of three months or less. We use quoted active market prices for identical assets to measure fair value. We had money market securities of approximately $1.3 million and $0 at December 31, 2012 and 2011, respectively.

CEO BACKGROUND

General

Our Board of Directors currently consists of four directors whose term of office expires at our annual meeting.
On July 17, 2010, Drs. Alexander K. Arrow and Norman J. Nemoy were appointed as Directors of the Company. On November 1, 2010, Mr. Gregory E. Lichtwardt was appointed as a Director of the Company.

Our Board, upon the recommendation of the Nomination and Corporate Governance Committee, appointed Mr. Federico Pignatelli as our interim Chief Executive Officer and Executive Chairman on August 27, 2010. On September 30, 2010, Mr. Pignatelli was appointed as our Chairman of the Board and Chief Executive Officer of the Company. Prior to his appointment as Chief Executive Officer, Mr. Pignatelli was our President and Chairman Emeritus of the Board.
The authorized number of directors on the Board is currently fixed at not less than three and not more than nine.

The four nominees to be elected at our annual meeting will serve until the 2014 Annual Meeting of Stockholders and until their successors have been duly elected and qualified or until their earlier resignation, removal, or death. All of our four nominees currently serve on our Board. Each of the director nominees has agreed to serve if elected. We have no reason to believe that any of the nominees will be unavailable to serve. Although it is anticipated that each nominee will be able to serve as a director, should any nominee become unavailable to serve, the proxies will be voted for such other person or persons as may be designated by our Board.

Our Board, upon recommendation from its Nominating and Corporate Governance Committee, has nominated the persons listed below for re-election to serve as directors for the term beginning at our annual meeting of stockholders on June 6, 2013.

Our Nominees/Directors

Federico Pignatelli, 60, has served as our Chief Executive Officer since August 2010, and as our Chairman of the Board and Chief Executive Officer since September 2010. Mr. Pignatelli previously served as our Chairman of the Board from 1994 until March 2006, at which point he became our Chairman Emeritus. Mr. Pignatelli has served as our President from January 2008 until June 2010. From November 2007 to January 2008, he served as interim Chief Executive Officer. Mr. Pignatelli has served as a director since 1991. He is the founder, and has served as President, of Art & Fashion Group since 1992. Art & Fashion Group is a holding company of an array of businesses providing services to the advertising industry, including the worldâ€™s largest complex of digital and film still photography studios for production and post-production. Previously, Mr. Pignatelli was a Managing Director at Gruntal & Company, an investment banking and brokerage firm, and was a Managing Director of Ladenburg, Thalmann & Co., also an investment banking and brokerage firm.

Alexander K. Arrow, M.D., CFA, 42, was appointed to the Board in July 2010. Dr. Arrow is the Chief Medical and Strategic Officer of Circuit Therapeutics, Inc., a company seeking to realize commercial potential in the field of optogenetics, a position Dr. Arrow has held since July 2012. Previously, Dr. Arrow was the Chief Financial Officer of Arstasis, Inc., a 115-employee cardiology device manufacturer. From 2002 to 2007, Dr. Arrow headed medical technology equity research at the global investment bank Lazard, providing research coverage on a wide variety of medical device manufacturers. Dr. Arrow also spent two years as Chief Financial Officer of the Patent & License Exchange, later renamed PLX Systems, Inc., and three years as the publishing life sciences research analyst at Wedbush Morgan Securities. In 1996, Dr. Arrow was a surgical resident at the UCLA Medical Center. Dr. Arrow received his CFA in 1999. He was awarded an M.D. from Harvard Medical School in 1996 and a B.A. in Biophysics, magna cum laude , from Cornell University in 1992.

Gregory E. Lichtwardt, 58, was appointed to the Board in November 2010. Mr. Lichtwardt is Executive Vice President, Operations, Treasurer, and Chief Financial Officer of Conceptus, Inc. (NASDAQ:CPTS), developer of the Essure Â® procedure, a non-surgical permanent birth control procedure. He joined Conceptus in November 2003 as Executive Vice President, Treasurer and Chief Financial Officer and was promoted to his current position in April 2008. From 2000 to 2002, he was Executive Vice President, Finance, Chief Financial Officer and Corporate Secretary of Innoventry, Inc., a financial services company. From 1993 to 2000, Mr. Lichtwardt was Vice President, Finance, Chief Financial Officer and Treasurer of Ocular Sciences, Inc., a worldwide developer and marketer of soft contact lenses. Prior to his employment with Ocular Sciences, Mr. Lichtwardt, from 1989 to 1993, held senior management positions in various divisions of Allergan, Inc. In addition to these positions, Mr. Lichtwardt has held various financial positions at AST Research, Inc. and at divisions of American Hospital Supply Corporation. He holds a B.B.A. degree from the University of Michigan and M.B.A. degree from Michigan State University.

Norman J. Nemoy, M.D., F.A.C.S., 74, was appointed to the Board in July 2010. Dr. Nemoy is a partner at Tower Urology Medical Group and is on the surgical attending staff at Cedars-Sinai Medical Center. Dr. Nemoy graduated from the University of Illinois, School of Medicine, and obtained his urological training at Stanford University Medical Center in Palo Alto, California. Following his training at Stanford, he had served on the clinical faculty at UCLA School of Medicine. He is a fellow of the American College of Surgeons, and is Board Certified by the American Board of Urology. Dr. Nemoy is an expert in advanced robotic surgery and has been involved in numerous clinical research studies designed to test the safety and clinical effectiveness of new urological drugs and devices.

Recommendation of Our Board

THE BOARD UNANIMOUSLY RECOMMENDS THAT YOU VOTE â€śFORâ€ť THE ELECTION OF EACH NOMINEE NAMED ABOVE.

MANAGEMENT DISCUSSION FOR LATEST QUARTER

Overview
We are a biomedical company that develops, manufactures, and markets proprietary lasers in dentistry and medicine and also markets and distributes two-dimensional (â€ś2-Dâ€ť) and three-dimensional (â€ś3-Dâ€ť) digital imaging equipment and CAD/CAM intra-oral scanners; products that are focused on technologies that advance the practice of dentistry and medicine. Our dental laser systems allow dentists, periodontists, endodontists, oral surgeons, and other specialists to perform a broad range of dental procedures, including cosmetic and complex surgical applications. Our systems are designed to provide clinically superior performance for many types of dental procedures with less pain and faster recovery times than are generally achieved with drills, scalpels, and other dental instruments. We have clearance from the U.S. Food and Drug Administration (the â€śFDAâ€ť) to sell our laser systems in the United States and also have the necessary approvals to sell our laser systems in Canada, the European Union, and various other international markets. Our licensed dental imaging equipment and other related products are designed to improve diagnoses, applications, and procedures in dentistry and medicine.

We offer two categories of laser system products: WaterLase Â® systems and Diode systems. Our flagship product category, the WaterLase system, uses a patented combination of water and laser energy to perform most procedures currently performed using dental drills, scalpels, and other traditional dental instruments for cutting soft and hard tissue. We also offer our Diode laser systems to perform soft tissue, pain therapy, and cosmetic procedures, including teeth whitening. We currently have approximately 170 issued and 130 pending U.S. and international patents, the majority of which are related to our core WaterLase technology and dental and medical lasers. Since 1998, we have sold over 10,000 WaterLase systems, including more than 6,000 WaterLase MD Â® and iPlus Â® systems, and more than 23,900 laser systems in over 70 countries around the world.

During the nine months ended September 30, 2013, we unveiled and began selling the new Epic TM V-Series diode laser system which we believe will be a leading technology in the evolution of dental and medical treatments available in the veterinary market. We also received FDA clearance for both the Diolase 10S and Epic 10S for over 80 different procedures in 19 additional medical markets, including general surgery, ophthalmology, dermatology, plastic surgery, ENT, oral surgery, arthroscopy, gastroenterology, podiatry, GI/GU, gynecology, neurosurgery, pulmonary surgery, cardiac surgery, thoracic surgery, urology, aesthetics, and vascular surgery. We continue to invest in our intellectual property and were granted several new patents covering the use of laser technologies for treating various conditions of the eye, including presbyopia, glaucoma, retinal disorders, and cataracts, several new patents for our laser delivery system configurations, and a new patent for our non-contact hand piece for cutting both hard and soft tissue with our WaterLase all-tissue lasers. The FDA also cleared the WaterLase iPlus all-tissue laser for use as a surgical instrument for soft-tissue procedures in orthopedic and podiatric surgery.

We are actively seeking strategic partnerships for our patented advanced technologies and recently entered into a letter of commitment with Auris Surgical Robotics, Inc. ("Auris") to co-develop a cataract-removal ophthalmologic robot utilizing our WaterLase technology and a robotic operating system manufactured by Auris. We also have a strategic agreement with Valam, Inc. (â€śValamâ€ť) to develop, market, and sell office-based laser systems to otolaryngologists (also known as "Ear, Nose, and Throat" or "ENT" doctors) (the â€śValam Agreementâ€ť). The Valam Agreement provides us with an exclusive worldwide license to Valamâ€™s ENT related patents and patent applications which complement our patent portfolio and supports our expected launch into the ENT laser market in late 2013. We are also engaged in collaboration with Procter and Gamble Company (â€śP&Gâ€ť) to commercialize a consumer product utilizing our patents. Recently we launched the OCCULASE TM website as a marketing tool for our ophthalmology technologies for which we continue to seek strategic partnerships to assist in our entry into the ophthalmology laser market.

During the nine months ended September 30, 2013, we expanded our line of digital imaging equipment with the newly FDA cleared NewTom Biolase VG3 (â€śVG3â€ť), a readily upgradeable 2-D/3-D hybrid system manufactured by Cefla Dental Group, which we began distributing in the United States. We also entered into an affiliation agreement with Sun Dental Laboratories, LLC (â€śSun Dentalâ€ť) by which we leverage Sun Dentalâ€™s existing relationships with dentists, laboratory associates, and dental practice customers to enhance sales of our imaging systems.

On July 26, 2013, we filed a registration statement on Form S-3, File No. 333-190158 (â€ś2013 Registration Statementâ€ť) with the Securities and Exchange Commission (â€śSECâ€ť) to register an indeterminate number of shares of common stock, preferred stock, and warrants with a total offering price not to exceed $30 million. We subsequently amended the 2013 Registration Statement and lowered the total not to exceed offering price to $5 million. The 2013 Registration Statement, as amended, was declared effective by the SEC on September 19, 2013. On September 23, 2013, we entered into an agreement with Northland Securities, Inc. (â€śNorthlandâ€ť), pursuant to which Northland acted as placement agent in connection with the sale of shares of our common stock in a registered direct offering (the â€śSeptember 2013 Registered Direct Offeringâ€ť) pursuant to the 2013 Registration Statement and paid Northland a fee of 5.0% of the aggregate gross proceeds in connection therewith. On September 23, 2013, we entered into a subscription agreement (â€ś2013 Subscription Agreementâ€ť) with Camber Capital Management, LLC, pursuant to which we agreed to sell 2,688,172 shares of our common stock at a price per share of $1.86 for gross proceeds of $5 million. The net proceeds to the Company were $4.6 million, after deducting associated costs of $408,000, which included Northlandâ€™s fee. The shares of common stock sold in connection with the 2013 Subscription Agreement were issued pursuant to a prospectus supplement to the 2013 Registration Statement, which was filed with the SEC September 26, 2013.

On September 6, 2013 and November 8, 2013, we amended our lines of credit with Comerica Bank. Further discussion of the amendments is included in our discussion on Liquidity and Capital Resourcesâ€”Future Liquidity Needs .

Critical Accounting Policies

The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America which require us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and revenues and expenses reported during the period. Information with respect to our critical accounting policies which we believe could have the most significant effect on our reported results and require subjective or complex judgments by management is contained on pages 48 to 51 in Item 7, Managementâ€™s Discussion and Analysis of Financial Condition and Results of Operations, of the Companyâ€™s 2012 Form 10-K. We believe that there have been no significant changes during the nine months ended September 30, 2013 in our critical accounting policies from those disclosed in Item 7 of the 2012 Form 10-K, except for our income tax provision for the three and nine months ended September 30, 2013 which was calculated using the discrete year-to-date method, which we determined to be more appropriate than the annual effective rate method which was used to calculate the income tax provision for the quarter ended March 31, 2013.

Results of Operations

Three months ended September 30, 2013 and 2012

Net Revenue . Net revenue for the three months ended September 30, 2013, (â€śThird Quarter 2013â€ť) totaled $12.3 million, a decrease of approximately $1.5 million, or 10%, as compared with net revenue of $13.8 million for the three months ended September 30, 2012 (â€śThird Quarter 2012â€ť). Domestic revenues totaled $7.6 million, or 62% of net revenue, for Third Quarter 2013 versus $9.4 million, or 68% of net revenue, for Third Quarter 2012. International revenues for Third Quarter 2013 totaled $4.7 million, or 38% of net revenue, as compared with $4.3 million, or 32% of net revenue, for Third Quarter 2012. The decrease in period-over-period net revenue resulted from decreases in domestic laser system revenue, which declined 32%, offset by increases in imaging systems, consumables and other, and services revenue. We believe that these results were primarily due to inadequate execution within our sales force and subpar marketing efforts in connection with our transition from only selling WaterLase dental lasers to selling a wide range of hard- and soft-tissue dental and medical lasers and other technological solutions for dentists, including digital radiography and CAD/CAM intra-oral scanners. With continued growth in international sales and entrance into new product markets we recently changed sales and marketing leadership responsibilities in efforts to more effectively deploy our resources and improve overall revenue as well as our gross margin.

Laser system net revenue, as a result of the aforementioned reasons, decreased by approximately $2.0 million, or 20%, in the Third Quarter 2013 compared to the same period of 2012. We expect improved sales of our core laser systems moving into the quarter ending December 31, 2013, as we believe many dentists purchase capital equipment during the fourth quarter in order to maximize their earnings and minimize their taxes through utilizing certain tax incentives, such as accelerated depreciation methods for purchased capital equipment, as part of their year-end tax planning.

Imaging system net revenue increased by approximately $286,000, or 42%, in the Third Quarter 2013, compared to the same period of 2012. The increase was driven by increased sales and marketing efforts and increased offerings at various value propositions.

Consumables and other net revenue, which includes consumable products such as disposable tips and shipping revenue, increased by approximately $123,000, or 8%, for Third Quarter 2013 as compared to the same period of 2012. This increase in consumables and other net revenue was primarily a result of auxiliary sales to our growing laser customer base.

Services net revenue, which consists of extended warranty service contracts, advanced training programs, and other services, increased by approximately $217,000, or 16%, for Third Quarter 2013, as compared to the same period of 2012. The increased revenue was due largely to increased follow-on sales related to our growing laser customer base and increased sales and marketing efforts in this part of our business.

License fees and royalty revenue remained relatively flat for the Third Quarter 2013 as compared to the same period of 2012.

Cost of Revenue . Cost of revenue for Third Quarter 2013 increased by approximately $1.0 million, or 14%, to $8.5 million, or 69% of net revenue, compared with cost of revenue of $7.5 million, or 54% of net revenue, for Third Quarter 2012. The increased cost as a percentage of revenue is a result of lower laser system sales and slightly increased international sales. Our laser systems generally have significantly higher margins than our licensed imaging systems and our domestic sales generally have higher margins than our international sales. We also recorded a provision of $1.0 million for excess and obsolete inventory during Third Quarter 2013 related to negative market trends and the decreased velocity of our inventory which significantly increased our cost of revenues.
Gross Profit . Gross profit for Third Quarter 2013 decreased by approximately $2.5 million, or 39%, to $3.8 million, as compared to $6.3 million for Third Quarter 2012. Gross profit decreased from 46% of net revenue for Third Quarter 2012 to 31% of net revenue for Third Quarter 2013. The decrease was primarily due to lower laser system sales and the provision for excess and obsolete inventory.

Operating Expenses . Operating expenses for Third Quarter 2013 increased by approximately $1.0 million, or 15%, to $7.7 million as compared to $6.7 million for Third Quarter 2012. The period-over-period increase in expense is explained in the following expense categories:
Sales and Marketing Expense . Sales and marketing expenses for Third Quarter 2013 increased by approximately $529,000, or 15%, to $4.2 million, or 34% of net revenue, as compared with $3.6 million, or 26% of net revenue, for Third Quarter 2012. The increase was primarily a result of increased payroll and consulting related expenses of $428,000, increased convention costs of $137,000, and increased media and advertising expenses of $127,000, offset by decreased commission expenses of $213,000. As such, we expect costs to increase slightly as a percentage of revenue for the year ending December 31, 2013 as compared with the previous year. As a result, we have recently changed our sales and marketing leadership to address these negative trends.
General and Administrative Expense . General and administrative expenses for Third Quarter 2013 increased by approximately $621,000, or 34%, to $2.5 million, or 20% of net revenue, as compared with $1.8 million, or 13% of net revenue, for Third Quarter 2012. We experienced increased payroll and consulting related expenses of $316,000, increased legal expenses of $295,000, of which $250,000 related to the defense of class action lawsuits (refer below to â€śLitigation and Contingenciesâ€ť), increased provision for doubtful accounts of $300,000, and increased investor relations expenses of $66,000, offset by decreased patent defense costs of $337,000. During the Third Quarter 2013, we insourced various patent filing related work which reduced patent attorney fees but increased payroll costs.

Engineering and Development Expense . Engineering and development expenses for Third Quarter 2013 decreased by approximately $218,000, or 18%, to $977,000, or 8% of net revenue, as compared with $1.2 million, or 9% of net revenue, for Third Quarter 2012. The decrease was primarily related to decreased payroll and consulting related expenses of $172,000 and decreased supplies costs of $53,000.

Excise Tax Expense . Beginning January 1, 2013, the Patient Protection and Affordable Care Act imposed a 2.3% medical device excise tax on certain product sales to customers located in the U.S. We incurred excise tax expenses of $89,000, or 1% of net revenue, for Third Quarter 2013.
Non-Operating Loss, Net

Loss on Foreign Currency Transactions . We realized a $16,000 gain on foreign currency transactions for Third Quarter 2013, compared to a $28,000 loss on foreign currency transactions for Third Quarter 2012 due to exchange rate fluctuations between the U.S. dollar and other currencies.
Interest Expense, Net . Interest expense consisted primarily of interest on our revolving credit facilities and amortization of debt issuance costs and debt discount. Interest expense totaled approximately $182,000 and $98,000 for Third Quarter 2013 and 2012, respectively. The increase was a result of higher borrowings under lines of credit that provided the necessary liquidity to increase operations.

Income Tax (Benefit) Provision . Our provision for income taxes was an expense of $22,000 for Third Quarter 2013, compared to an expense of $34,000 for Third Quarter 2012.

Net Loss . For the reasons stated above, our net loss was approximately $4.0 million for Third Quarter 2013 compared to a net loss of $548,000 for Third Quarter 2012.

Nine months ended September 30, 2013 and 2012

Net Revenue . Net revenue for the nine months ended September 30, 2013, totaled $41.2 million, an increase of approximately $2.9 million, or 8%, as compared with net revenue of $38.3 million for the nine months ended September 30, 2012. Domestic revenues totaled approximately $25.7 million, or 62% of net revenue, for the nine months ended September 30, 2013, versus $25.9 million, or 68% of net revenue, for the nine months ended September 30, 2012. International revenues for the nine months ended September 30, 2013, totaled $15.5 million, or 38% of net revenue, as compared with $12.4 million, or 32% of net revenue, for the nine months ended September 30, 2012. The increase in period-over-period net revenue was primarily attributable to increases in imaging revenue, which grew 94%, as well as increases in services and consumables and other revenue, which increased 13% due to auxiliary sales to our growing laser customer base.

Laser system net revenue remained relatively flat for the nine months ended September 30, 2013, compared to the same period of 2012. We expect improved sales of our core laser systems moving into the quarter ending December 31, 2013, as we believe many dentists purchase capital equipment during the fourth quarter in order to maximize their earnings and minimize their taxes through utilizing certain tax incentives, such as accelerated depreciation methods for purchased capital equipment, as part of their year-end tax planning.

Imaging system net revenue increased by approximately $1.6 million, or 94%, in the nine months ended September 30, 2013, compared to the same period of 2012. The increase was driven by increased sales and marketing efforts and increased offerings at various value propositions.

Consumables and other net revenue, which includes consumable products, such as disposable tips and shipping revenue, increased by approximately $401,000, or 9%, for the nine months ended September 30, 2013, as compared to the same period of 2012. This increase in consumables and other net revenue was primarily a result of auxiliary sales to our growing laser customer base.

Services net revenue, which consists of extended warranty service contracts, advanced training programs, and other services, increased by approximately $743,000, or 18%, for the nine months ended September 30, 2013, as compared to the same period of 2012. The increased revenue was due largely to increased follow-on sales related to our growing laser customer base and increased sales and marketing efforts in this part of our business.

License fees and royalty revenue increased by $52,000 or 40% for the nine months ended September 30, 2013, as compared to the same period of 2012.
Cost of Revenue . Cost of revenue for the nine months ended September 30, 2013, increased by approximately $5.3 million, or approximately 26%, to $26.0 million, or 63% of net revenue, compared with cost of revenue of $20.7 million, or 54% of net revenue, for the nine months ended September 30, 2012. This increase was primarily attributable to a higher percentage of revenue generated from lower margin products, which include imaging systems, and international sales. Our laser systems generally have significantly higher margins than our licensed imaging products and our domestic laser sales generally have higher margins than our international laser sales. The increase in international revenue as a percentage of total revenue has also adversely impacted the cost of revenue due to additional costs such as import duties, taxes, and customs clearance fees. We also recorded a provision of $1.0 million for excess and obsolete inventory during Third Quarter 2013 related to negative market trends and the decreased velocity of our inventory which significantly increased our cost of revenues.

Gross Profit . Gross profit for the nine months ended September 30, 2013, decreased by approximately $2.4 million, or approximately 14%, to $15.2 million, or 37% of net revenue, compared with gross profit of $17.6 million, or 46% of net revenue. The decrease was primarily due to higher sales of licensed imaging systems, which generally carry lower margins than our laser products, increased international laser sales, which generally carry a lower margin than our domestic laser sales, and the provision for excess and obsolete inventory.

Operating Expenses . Operating expenses for the nine months ended September 30, 2013, increased by approximately $2.9 million, or 13%, to $24.2 million as compared to $21.3 million for the nine months ended September 30, 2012. The period-over-period increase in expense is explained in the following expense categories:

Sales and Marketing Expense . Sales and marketing expenses for the nine months ended September 30, 2013 increased by approximately $2.2 million, or 19%, to $13.6 million, or 33% of net revenue, as compared with $11.4 million, or 30% of net revenue, for the nine months ended September 30, 2012. The increase was primarily a result of increased payroll and consulting related expenses of $931,000, increased convention costs of $616,000, increased media and advertising expenses of $487,000, and a one-time benefit realized in the prior year related to the termination of a distributor arrangement of approximately $250,000, offset by decreased commission expenses of $188,000. As such, we expect costs to increase slightly as a percentage of revenue for the year ending December 31, 2013 as compared with the previous year. As a result, we have recently changed our sales and marketing leadership to address these negative trends.
General and Administrative Expense . General and administrative expenses for the nine months ended September 30, 2013 increased by approximately $1.0 million, or 16%, to $7.3 million, or 18% of net revenue, as compared with $6.3 million, or 16% of net revenue, for the nine months ended September 30, 2012. We experienced increased legal expenses of $426,000, of which $250,000 related to the defense of class action lawsuits (refer below to â€śLitigation and Contingenciesâ€ť), increased payroll and consulting related expenses of $308,000, and increased investor relations expenses of $221,000.

Engineering and Development Expense . Engineering and development expenses for the nine months ended September 30, 2013, decreased by approximately $670,000, or 18%, to $3.0 million, or 7% of net revenue, as compared with $3.7 million, or 10% of net revenue, for the nine months ended September 30, 2012. The decrease was primarily related to decreased supplies costs of $386,000 and decreased payroll and consulting related expenses of $339,000.
Excise Tax Expense . Beginning January 1, 2013, the Patient Protection and Affordable Care Act imposed a 2.3% medical device excise tax on certain product sales to customers located in the U.S. We incurred excise tax expenses of $308,000, or 1% of net revenue, for the nine months ended September 30, 2013.
Non-Operating Loss, Net

Loss on Foreign Currency Transactions . We realized a $74,000 loss on foreign currency transactions for the nine months ended September 30, 2013, compared to a $137,000 loss on foreign currency transactions for the nine months ended September 30, 2012, due to exchange rate fluctuations between the U.S. dollar and other currencies.

Interest Expense, Net . Interest expense consists primarily of interest on our revolving credit facilities, amortization of debt issuance costs and debt discount, and the financing of our business insurance premiums. Interest expense totaled approximately $386,000 and $140,000 for the nine months ended September 30, 2013 and 2012, respectively. The increase was primarily a result of increased year-to-date borrowings under lines of credit for the nine months ended September 30, 2013.

Income Tax (Benefit) Provision . Our provision for income taxes was a benefit of $182,000 for the nine months ended September 30, 2013, compared to an expense of $97,000 for the nine months ended September 30, 2012. During the nine months ended September 30, 2013, we reversed certain deferred tax liabilities associated with unrecognized tax benefits related to international operations due to expiring statutes and recognized tax benefits of $107,000. In addition, we recognized deferred tax assets related to certain indefinite lived assets (federal alternative minimum tax credits and California R&D credits) that were used to offset deferred tax liabilities related to indefinite-lived intangible assets. This resulted in additional tax benefits of $107,000. We also recorded an income tax expense of $32,000 for the current year tax provision.

Net Loss . For the reasons stated above, our net loss was $9.2 million for the nine months ended September 30, 2013, compared to a net loss of $4.1 million for the nine months ended September 30, 2012.

On the call with me is our Chairman and CEO, Federico Pignatelli and our CFO, Fred Furry. Federico will make some opening remarks and then he will turn the call over to Fred to run through our results and comparisons to prior periods. After Fredâ€™s discussion I will discuss some of our business and clinical highlights. We will then open the call for your questions.

Before we begin our comments today is Veterans Day and weâ€™d like to acknowledge and thank all of our Veterans and those currently serving in the branches of our military for their dedication to our country and their sacrifice, some of whom have made it possible for those lucky enough to work in business to do what we do.

Now please be aware there are number of forward-looking statements will be made during these presentation. Forward-looking statements are any statements that are not historical facts and can be identified by the words and phrases including, can be, may affect, may depend, believe, estimate, project, and similar words or phrases. These forward-looking statements are based on BIOLASEâ€™s current expectations and are subject to a variety of known and uncertain risks and uncertainties that could cause the companyâ€™s actual results to differ materially from the statements contained in this presentation.

These risk factors are discussed in the companyâ€™s filings with the SEC. BIOLASE cautions you that any forward-looking information provided is not a guarantee of future performance. Any forward-looking statements represent the companyâ€™s views only as of today and should not be relied upon as representing our views on any subsequent date.

For the benefit of those listening to this on a replay this call was held and recorded on November 11, 2013. A replay of the call will be available on the BIOLASE website shortly after this callâ€™s completion. When listening to this call please refer to the press release issued earlier today announcing the companyâ€™s results for the quarter and nine months ended September 30, 2013. If you do not have a copy of this release it is available on the BIOLASE website at www.biolase.com. The companyâ€™s results for the third quarter and nine months ended September 30 can also be found in the companyâ€™s September 30, 2013 Form 10-Q, which the company will file with the Securities & Exchange Commission. Note that the SEC is closed today so both these 8-K containing the earnings release and the 10-Q will be filed tomorrow morning.

With that, I would like to introduce Federico Pignatelli. Federico, please go ahead.

Federico Pignatelli - Chairman and Chief Operating Officer
Thank you, Alex, and good afternoon everyone. I want to welcome you all to our 2013 third quarter and nine months results conference call. Today we will review the BIOLASEâ€™s progress in 2013 and discuss several key initiatives that really impact the coming quarters.

First, let me briefly recap the nine months and third quarter ended September 30, 2013. Despite the fact that net revenues have increased by approximately $2.9 million or 8% to $41.2 million from the nine months ended September 30, 2013, as compared to revenues of $38.3 million for the prior year period our revenues for the third quarter decreased compared to the prior year quarter. Net revenues for the third quarter totaled $12.3 million, a decrease of approximately $1.5 million compared to $13.8 million in the prior year quarter.